Analysis: Why The May Nonfarm Payroll Report Raises The Likelihood That The Federal Reserve Will Start 'Tapering' Its Heavy Bond Purchases

The better-than-expected May nonfarm payroll report raises the likelihood that the Federal Reserve will begin to wind down its $85 million-per-month purchases of Treasurys and mortgage-backed securities.

Known as quantitative easing, the third and latest round of monetary easing, also known QE3, began in September 2012 as an initiative to lower long-term interest rates and, thus, stimulate business borrowing and, in turn, job creation. The Fed has said until recently that it would continue the quantitative easing, effectively money printing, until the national unemployment rate falls to 6.5 percent.

Lately, however, the U.S. central bank, which is headed by Chairman Ben Bernanke, has signaled its intent to begin winding down the purchases, even though the unemployment rate has been well above 7 percent. Much of the chatter about such a development reflected a view that the economy, which remains sluggish, continues to slowly gain speed and is in fact in an authentic recovery -- albeit the slowest recovery in the nation’s history.

Prospects that the Fed will indeed trim purchases sparked a violent sell-off last month in Treasurys.

The Labor Department’s May nonfarm payroll report came in better than expected, with 175,000 jobs created instead of the approximately 160,000 -- or less -- expected by the majority of professional analysts. The unemployment rate rose to 7.6 percent from 7.5 percent, but that was because more people were looking for work. The stronger-than-expected number lent credence to the idea that the economy is on a genuine recovery path and not in as great a need of monetary assistance as was the case last September when the central bank started its unprecedented program of massive bond buying.

“We think this leaves the Fed on track to taper QE3 later this year,” Paul Dales, senior U.S. economist for London's Capital Economics, said. “May’s gain was better than April’s 149,000 rise (revised down from 165,000) and takes jobs growth a bit closer to the monthly average of 200,000 seen in the previous six months,” he said.

“The weak tone of the recent survey evidence suggests payrolls may weaken a bit in the coming months. But we don’t think it will be long before they return to gains of around 180,000 a month. If that is the case by the time the Fed meets in September, then it will probably trim the pace of its monthly asset purchases.”

Goldman Sachs’ Jan Hatzius also deemed the report to be relatively strong. Hatzius said he sees “a very modest sequester impact apparent in today’s report. The diffusion index, which measures how widespread job gains were across industries, rose to 59.8, from 55.6. Revisions to the prior two months reduced net payroll gains by a modest 12,000.”

Steve Blitz, chief economist for ITG, said the May nonfarm payrolls report “keeps the possibility of tapering on the table.”

“I think it puts to rest the notion that the economy is going into a swoon as it did last year this time. It’s still disappointing in terms of the rate at which new jobs are being created. But there is a clear upturn in hours worked, upturn in people looking for work. So if you look at it from the point of view of direction -- not overall level -- the glass is half-full. It shows that we are improving from the level we have been at over the last few months. It certainly shows the economy is not shrinking and on some sort of growth path.”

Even before Friday's jobs report, a consensus was emerging that the money printing would shortly wind down.

Richard X. Bove, vice president of equity research for Rafferty Capital Markets, wrote on Monday that the process could begin within weeks.

"It now seems highly likely that these spikes in Fed activity are coming to an end," he wrote. "I expect that the Federal Reserve Bank will begin tapering off its monthly purchases beginning in late summer. By spring 2014, all monetary stimuli may be gone."